Berlusconi's Last Stand

Open Europe has today published a note on the dramatically evolving situation in Italy, with new estimates on how much the rising bond yields could cost the Italian government and an assessment of the current political situation.

Key points:

Berlusconi’s majority in the lower house of the Italian parliament remains uncertain;

If Berlusconi falls, the best option for Italy and the eurozone would be a national unity government with a strong backing in Italian parliament;

Italy could face an extra €28bn in interest payments over the next three years, potentially wiping out almost half of the projected €60bn budget savings by 2014;

Italy needs widespread institutional as well as economic reforms if it is to return to economic growth.

“Another decade of stagnation a major risk…Another decade of disappointing growth would make public debt difficult to sustain…Declining public bond prices would worsen banks’ and insurance companies’ balance sheets, with a possible vicious cycle.” -

IMF Staff Report on Italy, July 2011

The last week has seen Italian borrowing costs consistently increase (and thus prices fall) despite purchases by the European Central Bank. This is mostly down to the political deadlock in Italy and the increasingly untenable position of Prime Minister Silvio Berlusconi. In this briefing note, Open Europe looks at the economic and political situation in Italy and how it could unfold over the coming days and weeks.

This morning, Italian 10 year borrowing costs reached a record 6.74%, very close to the 7% threshold which financial markets see as broadly unsustainable (and which therefore often results in a self-fulfilling solvency crisis and possibly a bailout). Similar increases have been seen across the board for Italian debt of all maturities. Worryingly, short-term debt is becoming increasingly expensive (the yield curve is flattening) a sign that investors see increased risk in short-term lending (something seen in the other countries which accepted bailouts).

However, rumours of Berlusconi’s resignation triggered a rebound-effect on the stock markets yesterday. There should be no doubt that although Italy’s difficulties will not be resolved if Berlusconi goes, he is definitely a big part of the problem. So will Berlusconi resign, and what will it mean for Italy and the eurozone?

WHERE ARE WE AT?

Reports in the Italian press yesterday seemed to suggest that Berlusconi’s resignation was a matter of hours away, but Berlusconi personally intervened to deny the rumours as “groundless”. Significantly, the rumours of an imminent resignation triggered a rebound-effect on the stock markets;

Italy’s Interior Minister Roberto Maroni – a prominent member of junior coalition partner Lega Nord – has effectively acknowledged that, if the governing coalition no longer holds a majority in both the houses of the Italian parliament, “there’s no use resisting”. Yesterday, several Italian papers suggested that Lega Nord had asked Berlusconi to step down and hand over power to another member of his party (an offer which Il Cavaliere refused). Even the Secretary-General of Berlusconi’s party Angelino Alfano, who owes much of his career to Berlusconi, reportedly urged him to resign. On the international front, both IMF Chief Christine Lagarde and French Foreign Minister Alain Juppé have stressed that Italy has a problem of credibility (although they didn’t mention Berlusconi explicitly). However, Berlusconi has been in this situation many times before and can still hold out;

In terms of his parliamentary majority, three MPs from Berlusconi’s party have defected to the Christian Democrats’ group in the lower house of the Italian parliament, the Camera dei Deputati. In addition, six MPs from his own party sent Berlusconi a letter last week urging him to resign, meaning that Berlusconi could be on the verge of losing his support in parliament (315 votes would be required for him to pass a confidence motion in the lower house, provided that all of Italy’s 630 MPs take part in the voting). At the most recent vote of confidence in the Camera dei Deputati, on 14 October, Berlusconi got 316 votes – only one vote above the arithmetical majority;

Today, the Camera dei Deputati is to vote again on the 2010 budget review. This is not a vote of confidence in itself, so a loss wouldn’t mean the government collapsing immediately. However, it would be a politically significant test for Berlusconi’s majority;

In addition, Italy’s opposition parties have threatened to present a no-confidence motion, possibly as early as this week, if Berlusconi refuses to step down voluntarily.

A final decision is expected later this morning.

WHAT SHOULD HAPPEN IF BERLUSCONI FALLS?

Early elections should be avoided for at least two reasons:

Time is running out, and although Italy is a far richer country than Greece or Portugal, it just can’t sustain such high borrowing costs in the long run, even if below the 7% threshold;

Going to elections now would mean handing over the country to a centre-left coalition which would almost certainly have to rely on small leftist/former communist parties. It’s hard to imagine these parties pushing ahead with liberalisation of the labour market, easier dismissals, wage cuts and pension reform – all needed to get the Italian economy back on track.

The Italian President, Giorgio Napolitano, could task another prominent member from Berlusconi’s party with forming a new cabinet and try to obtain the confidence of the parliament. However, the two main options in terms of competence and experience – Economy Minister Giulio Tremonti and the Undersecretary to the Presidency of the Italian government, Gianni Letta – both look politically unfeasible at the moment. Tremonti is politically isolated and would never be backed by a large majority of Berlusconi’s MPs, while none of the centre-left parties would support Letta, who is considered too close to Berlusconi;

Given this, the best way forward for Italy some sort of government of national unity led by a cross-party figure. There has been a lot of talk about former EU Commissioner Mario Monti leading such a cabinet. He would be a strong candidate for a series of reasons – for example, his reputation in Europe is intact, he would back liberalisation of Italy’s labour market and would be able to draw support from both sides of the political spectrum;

Both Berlusconi and Lega Nord have so far voiced opposition to the formation of any sort of ‘transitional government’ at the moment. However, a cross-party figure like Mario Monti would almost certainly be supported by the centre-left opposition. In addition, after the latest events, Berlusconi MPs no longer form a united voting bloc in the Italian parliament, and a number of them could eventually back Mario Monti;

In terms of duration, such a government could stay in place until next year, when early elections are held. This has the advantage of giving voters a say over important government policy in the near future and removes the threat of having a broadly unelected government in place for a long period. Due to the uncertainty of the Italian political scene, it may be necessary to put off the elections until 2013 (when the next election is due to take place) – but that would clearly jeopardise democratic principles;

If a cross-party government of this kind could draw wide-spread support in the Italian Parliament, it would be possible to reconcile the need for adhering to democratic principles, and add stability and credibility to on-going reforms, in Italy – as markets will know that these reforms will not be quickly reversed;

An added incentive for such a cross-party government – as mundane as it may sound – is that new-intake MPs would not be entitled to their pensions if they fail to end the parliamentary term. Also, a good number of MPs from Berlusconi’s party would seriously risk losing their seats if elections were to be called – say – in January, whereas if they stick around a bit more they can try and re-gain some confidence among Italian voters.

HOW LONG CAN ITALY SUSTAIN HIGHER BORROWING COSTS?

Italy’s funding needs over the next three years are between €825bn and €907bn. This is broken down as follows:

Italy has €173.3bn in short term and long term debt maturing for the rest of this year, while between 2011 and 2014 Italy has €656.4bn maturing;

Additionally, the Italian deficit over this period is estimated to be €128.5bn, assuming full implementation of the latest budget package, which aims to balance the budget by 2013;

However, if this is not achieved and Italy continues along its current deficit path, it is possible the deficit over the next three years could be €210.6bn. The IMF estimates that Italian banks need €40bn in new capital in the short term.

Open Europe estimates that rolling over expiring debt at the higher rates seen today will cost Italy an extra €27.8bn over the next three years and up to €58.7bn over the next five years. Given the size of Italy’s economy this is not disastrous, but would undo a significant amount of the €60bn in budget cuts by 2014. Considering the difficultly in passing these measures (which are yet to be implemented) this could easily cause Italy to miss its debt and deficit targets over the next few years. In addition to the markets losing faith in Italian finances, it would further the growing political division between the EU/IMF and the Italian government;

At these higher yields, rolling over its existing debt load would cost Italy an extra €225bn over the life of the debt. Combined with low growth, this could have a substantial impact on Italy’s longer term debt sustainability. Italy could still absorb higher borrowing costs for a few months given its low average interest rate and the liquidity of its bond market. However, it is clear investors are beginning to lose patience and need to see some progress soon.

WIDER ECONOMIC PROBLEMS

There are some signs of an export driven recovery: but this is still outweighed by imports. Many of the traditional Italian exports are in direct competition with those produced in emerging markets (manufactured goods, textiles, generally low value added products which need massive volumes

Italy can no longer compete with these countries on a cost basis);

High taxes but relatively poor public services: There is lots of scope to reduce expenditure or make it more efficient, which can easily be coupled with pro-growth policies. However, there remain significant political obstacles to this, since it would likely require a change in government, reforms of regional institutions and of the wider tax code. Italy has the highest public sector payment delays in eurozone and biggest recent increase, indicative of bureaucratic problems;

50% of unemployed are long term unemployed: This is a tough problem to solve, and requires strong supply side policies – such as investment in education and retraining programmes– not just increases in demand.3 Long term unemployment eventually feeds through to and hampers long term productivity in the economy. There is also a deeply embedded dual labour market – which leads to older protected workers and high youth unemployment. This feeds inequality and has been exacerbated by the recent crisis.

WHAT ARE THE NEXT KEY DATES?

Today: The 2010 budget review is to be put to a second vote in the lower house of the Italian parliament. The vote is expected to pass, as opposition MPs have reportedly decided to abstain. However, the outcome of the vote will be hugely significant, because it could conclusively show that Berlusconi no longer holds an arithmetical majority in the Camera dei Deputati;

By the end of this week: The leader of Italy’s main opposition party, Pier Luigi Bersani, has said that Italy’s opposition parties intend to present a no-confidence motion, possibly by the end of this week, regardless of the outcome of tomorrow’s vote on the 2010 budget review. However, a final decision on the date of the motion is expected later this morning;

Within the next two weeks: Berlusconi has committed to adopting the economic reforms outlined in the letter to EU leaders by the end of November. To do so, he said he would put the measures to a vote of confidence in the Italian parliament. If the government fails to win a vote of confidence in any of the houses of the Italian parliament, the political crisis immediately expands and the Italian President has to start discussions with the leaders of the main political groups to figure out what the best thing to do is (e.g. dissolve parliament and go to early elections, appoint a new Prime Minister from the same majority, appoint a technocrat as a Prime Minister);

However, uncertainty remains over the date when the measures outlined in Italy’s letter to the EU and the ECB will actually be put to a confidence vote. Berlusconi denied rumours of him being close to resignation yesterday, and insisted that, after tomorrow’s vote on the 2010 budget review in the lower house of the Italian parliament, he would “put the letter sent to the EU and the ECB to a vote of confidence,” adding, “I want to look in the face those who are trying to betray me.” Immediately after today’s vote, provided that Berlusconi wins it, the new package of measures will be presented to the Italian Senate’s Budgets Committee. A vote in the Italian Senate (where Berlusconi currently holds a safer majority) is therefore expected not earlier than next week. The Camera dei Deputati will discuss and vote the measures only after that.